Count to Three -- Market Commentary from CBIS Chief Investment Officer Frank Haines
A wonderful bit of wisdom which I try to employ in moments of irritation is to take a deep breath and count to three, before saying something that I might later regret. Of course, it’s often easier said than done!
This wisdom lends itself to broader application, specifically the art of investing. One of the classic errors that investors / investment committees can make is to reach decisions based upon recent events, reacting as much emotionally as objectively. Stepping back from immediate events – particularly market declines or sensationalized financial news – taking a deep breath, and putting decisions in context can often be the best approach to achieving long term investment goals.
Consider the sharp spikes in stock market volatility over the past several weeks. The Dow Jones Industrial Average fell 416 points on February 27 (3.3%), seemed to stabilize subsequently, and declined a further 243 points (1.97%) on March 13th. The deterioration and widespread impact of subprime mortgage lending was the most commonly cited cause, although concerns about slowing global GDP growth and rising interest rates abroad may have contributed. Yet such corrections may simply have been long overdue in a stock market that has been characterized by historically strong earnings growth, ample liquidity and a substantial reduction in shares outstanding through LBOs and share buyback programs. Stock market volatility may have simply recovered from unusually low levels to more normal conditions.
Since the stock market multi-year decline from 2000 through early 2003, stock markets in the U.S. and overseas have been unusually strong, with few brief corrections. From the stock market recovery in March 2003 through February 2007, the S&P 500 has posted positive monthly returns more than 75% of the time, and the EAFE international equity index more than 80% of the time. This contrasts sharply with average stock market conditions over the past 75 years, in which a decline of 10% or more in a given year is not uncommon. In terms of magnitude, a 500 point decline, which was achieved at one point on February 27th, now represents 3% of the DJIA’s market capitalization. The same 500 point decline on Black Monday, October 19, 1987, a shocking event for investors at the time, represented a 22% drop!
One method of stepping back and taking a deep breath might be to observe cumulative stock market results, both in the U.S. and overseas, over the past twenty years. The devastating (if you experienced it!) October 1987 decline appears as little more than a speed bump on the upward trend of the S&P 500, similar to the declines of 1990 (banking and financial crisis) and 1998 (Long Term Capital, Russian debt default and Asian currency crises). Even the bear market of 2000 to 2002, correcting some of the valuation excesses of the “Bubble Market”, seems like ancient history. Corrections and volatility are a normal part of stock investing, as prices swing from excessive optimism to pessimism around intrinsic company values.
What action is required in light of recent stock market declines? Take a deep breath, and ask yourself:
1) Is the broad market suffering from deteriorating conditions, or are causes relatively specific? Both the stock and bond markets have been pricing risk far too lightly, whether that is mortgage risk in the form of subprime lending and lax underwriting, or in regard to leverage and proliferation of untested Collateralized Debt Obligation (CDO) and Credit Default Swap (CDS) securities. Nevertheless, the global economy is still growing, interest rates are moderate to accommodative (in 1987, the stock market had to compete with 9% Treasury yields), corporations have substantial cash, and private equity acquisitions continue to set records in retiring public securities. While corrections are inevitable, market conditions still look favorable.
2) How exposed are we to risks such as subprime exposure? It is one thing to accept stock volatility in order to achieve the upside of stocks longer term, but it shouldn’t be necessary to accept calamitous risks. CBIS monitors our participants’ bond and stock programs for risks that we believe to be unrewarded or difficult to measure, such as subprime and Alt A (the tier above subprime) mortgage exposure. Due to heavy issuance over the past several years, such debt permeates many investment vehicles, ranging from money market funds to securitized CDO and asset-backed structures/bond mutual funds, and affects banks, hedge funds and insurance portfolios and their share prices. Our RCT programs have emphasized high quality and have exposure only in the Flex Cash Fund to a small percentage of short asset-backed home equity loans (AAA-rated tranches), while our CUIT equity programs have no direct equity exposure to subprime issuers (although the CUIT Market Neutral Fund is short several subprime lenders), only to diversified global banks and insurers with diverse operations, in some cases including subprime lending subsidiaries.
3) Should investors reduce stock exposure “temporarily” until conditions stabilize? The classic conundrum of the investor timing the market is he/she has to be right twice, both on getting out and getting back in. It’s difficult enough to be right once on the timing. I recall many investment committees that pulled back equity exposure in 1987 (in part due to those attractive bond yields!) but then never decided the time was right to re-enter the market. In the meantime, the stock market recovered within 2 years to its pre-crash level, and rose steadily from there.
Professional investment managers know that there is no signal when it’s appropriate to enter or leave the market, and they must rely on a long term philosophy of investing to judge opportunities. The successful ones have learned to tune out the day-to-day noise of the market, and distance themselves from short term emotions, if they want to survive in the investment business. This is appropriate advice for financial fiduciaries, as well.